How Jack Bogle Changed Investing

By

Lewis Braham

Updated Jan. 18, 2019 1:12 p.m. ET

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Photograph by Ken Cedeno/Bloomberg News

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The superstitious have called it the devil’s invention. Fools, a communist threat. I call it the most efficient profit extraction machine ever invented. Regardless what you call it, one thing is certain—Jack Bogle’s creation, the index fund, is here to stay. There’s more than $13 trillion invested in index or passively-run mutual and exchange-traded funds worldwide, more than half of that at Vanguard Group, BlackRock, and State Street alone.

Originally, there was another nickname for the index fund that captures the personal risk it was to its creator—Bogle’s folly. “The fund was called Bogle’s folly because it was not a commercial success and wasn’t for some period,” says Burton Malkiel, author of A Random Walk Down Wall Street, the book that so popularized indexing it’s now in its 12th edition. “It’s fine for me as an academic writing books about the stock market to say that you ought to be invested in an index fund. It’s quite another thing to bet your company on it and have your fund being called ridiculous and un-American.”

What the index fund was originally, though, and what it is today is like looking at two completely different animals. When Vanguard launched the appropriately-named First Index Investment Trust in August of 1976, it tracked the
S&P 500
—a widely diversified and well-known benchmark. (Later the fund was redubbed
Vanguard 500 Index
[ticker: VFINX].) Today, you can buy ETFs like
ETFMG Alternative Harvest
(MJ), which tracks the Prime Alternative Harvest index of marijuana-related stocks, or trade the leveraged
ProShares UltraPro QQQ
(TQQQ), which triples the daily return of the Nasdaq 100 index.

Such niche products were an anathema to Bogle. He believed in buying and holding the stocks in the broadest benchmarks possible to capture the entire market’s moves. The hoary
Vanguard Total Stock Market Index
(VTSMX) was his ideal. The idea was what Bogle comically called his “Cost Matters Hypothesis.” If everyone invested in the market collectively makes the market, then—after deducting trading costs and management fees—the average investor would lag the market.

Given that the random moves of stocks—Malkiel likened them to a “blind chimpanzee throwing darts” at a newspaper’s stock pages—could do as well as the average investor, betting on a narrow market slice was a fool’s errand and really active management in disguise.

By minimizing costs and indexing the broadest benchmark, Vanguard Total Stock Market has beaten 87% of its fund peers in the past 15 years. Yet both of the aforementioned niche ETFs have proven more successful at gathering assets than Bogle’s folly originally was. It took more than 11 years for Vanguard 500 Index to cross the $1 billion asset mark. In little over a year, the ganja ETF already has $762 million, yet it charges fees—0.75%—comparable to active funds, doubly insulting to Bogle’s concept of indexing. The leveraged Nasdaq ETF has $3.5 billion and charges 0.95%.

“You can take indexing too far, and I think the fund industry has taken it to an absurd level where investors can’t even begin to comprehend what various funds are offering,” says Gus Sauter, who managed Vanguard’s equity index funds from 1987 through 2012, eventually becoming the firm’s chief investment officer. “There’s been a lot of research done that indicates if you offer investors too many choices, you create gridlock. You’ve got that in the index business now.”

Still, the bulk of assets continue to go into more diversified index funds. “The biggest inflows for ETFs in 2018 were to well-diversified, low-cost iShares, Vanguard, Schwab, and State Street products,” says Todd Rosenbluth, CFRA’s Director of Mutual Fund and ETF Research. “But there’s a parallel investment argument being made—individual stocks or individual bonds used to be what active managers used to beat the market. Now what we’re seeing is that index-based products are part of that mix.”

That index funds are being used for active management goes beyond simply the kinds of funds offered, but how investors are using them, including the broadly diversified ones. When I interviewed Bogle for my biography of him, The House That Bogle Built, he was extraordinarily skeptical about the frequency with which people were trading even broadly diversified S&P 500 ETFs.

In fact, when Nathan Most, the creator of the first ETF, first approached Bogle with the idea of launching an S&P 500 one, Bogle rejected him. Most went to State Street instead, which launched the
SPDR S&P 500
ETF (SPY) in 1993. Some saw this as a crucial mistake on Bogle’s and Vanguard’s part from a business perspective.

“Basically, Jack’s argument was why would anybody want to go and buy the market at 10:30 in the morning and then sell it at two o’clock in the afternoon,” Malkiel says. “The counter to that is there are some people probably who will use [ETFs] for speculation but when they do that in the context of the mutual funds they can creating [tax and trading] costs for the other people in the fund. The ETF has a very important potential tax advantage over mutual funds.”

Indeed, the structure of the ETF allows fund companies to get appreciated stock out of the funds without distributing taxable gains to shareholders. But the same structure, by design, invites trading. Bogle would repeatedly cite stats indicating that returns for investors in ETFs tracking the same index as comparable index mutual funds were lower because of poor trading decisions. He loved to say “strategy follows structure.” Something designed to be traded will thus be traded—to many investors’ detriment.

That same motto applies to Vanguard itself. While almost every large fund company now offers some indexed product, Bogle’s greater invention, I would argue, is Vanguard’s at-cost quasi-nonprofit structure, and thus far, no other company has copied it. That structure Bogle started led Vanguard to launch index funds. In a 1995 speech at Harvard University titled “Strategy Follows Structure,” he remarked about indexing’s advantages that given “the elementary mathematics of the market, that insight is so startlingly obvious that it must have been shared by many other firms in the industry.”

For-profit fund companies have two sets of shareholders, or two masters, as Bogle called them—management company shareholders and fund shareholders. The former wants to generate as much management fee profits at the expense of the latter. Vanguard gives all cost savings back to shareholders, so a low-cost index product is a natural evolution. In fact, bonuses inside the company are determined by how much cost savings Vanguard has delivered to shareholders versus their industry peers as a percentage of assets under management. The goal always is to drive costs down, and nothing is cheaper and more efficient to run than an index fund.

“We’ve heard a lot about the fact that Jack created the first index mutual fund,” says Sauter. “But the most important thing Jack ever created was Vanguard itself—its mutual structure—whereby Vanguard is owned by the investors in its funds. If Jack hadn’t created that structure, Vanguard would have simply had high-cost index funds, and high-cost index funds makes no sense. That structure is what has put tremendous cost pressure on the fund industry.”

That said, a cost-based incentive system encourages asset growth. Herein lies a flaw in Vanguard’s model. Vanguard wants to gain as much scale as possible to generate the biggest bonuses for its employees. (A percentage bonus of $1 trillion of cost savings equals a bigger bonus than $1 billion.) That can incentivize the firm to launch dubious products or strategies to gather more assets. Thus Vanguard now has several ETFs, and its brokerage platform charges no transaction fees to trade any ETF. If anything encourages speculative trading, it’s that.

Still, most of the criticisms of the company and Bogle’s beloved index funds seem illegitimate sniping by active managers who are seeing their fees compressed. Perhaps the most ridiculous was the August 2016 Sanford C. Bernstein report entitled: “The Silent Road to Serfdom: Why Passive Investment is Worse Than Marxism.” In it, the author argued that the collective ownership of the market via indexing led to poor capital allocation, worse than Marxism because it was indiscriminate.

Yet, if anything, the index fund is the epitome of capitalism. It’s the ultimate disruptive technology that brings costs down for consumers in a free, competitive market for money management. The cost of that money management is a fundamental part of capital-allocation decisions for fund investors, one that has proven more predictive of their ultimate returns than any other metric.

Normally, free-market-loving money managers celebrate such disruptive technologies, as they increase profits for shareholders, even if it ultimately costs employees in the industry being disrupted their jobs. In this case, managers don’t like it because it’s their jobs on the line, while fund shareholders benefit—a form of poetic justice if ever there was one for the people Bogle called “the croupiers of Wall Street.”

“Every active manager in the world is threatened by the concept of indexing,” says Sauter. “It’s a huge competition to their business, and active management is shrinking relative to the pie. Managers since the beginning have tried to point out or manufacture things that are supposedly wrong with indexing. There’s still plenty of active management going on, so I don’t worry about market efficiency.” Bogle said the market could be 50% indexed before it would have any impact on market efficiency, while Malkiel says it could be as high as 90%.

If there is a problem with indexing, it’s that it caused the profit seeking and active management to shift downstream. It’s fostered a huge shift in the financial-advisory business. Financial planners charging clients 1% of assets under management routinely use index funds in their portfolios to make that 1% more palatable. But the evidence from adviser surveys indicates too many are actively trading their funds in a feeble attempt to outperform the market, defeating the purpose of indexing.

Vanguard is attacking this adviser model too. Its hybrid human/robo-advisory service, Vanguard Personal Advisor Services, charges only 0.3% and is rapidly gathering assets. It’s another cost-saving innovation that would make Bogle beam.

Actually, Bogle rather enjoyed being called a communist. He hung a poster on the wall at Vanguard of a 1970s advertisement from rival money manager Leuthold Group that depicted Uncle Sam rubber-stamping an index fund prospectus “un-American.” At a 1990 conference at the fund trade group Investment Company Institute, a speaker publicly stated he was worse than a communist, and more like a Bolshevik. Afterward, Bogle approached the speaker, thanked him for the characterization and joked: “In the office I am often called a fascist.” In reality, his index fund was as American as apple pie.

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